Wednesday, April 22, 2009

Maturity Kills: Operating Statement Defaults Versus Balance Sheet Defaults

No question CRE rents are falling and vacancy rates are rising, and these trends are getting a lot of attention (see, for example, Calculated Risk posts here, here, and here, and Zero Hedge posts here, and here). However, this threat is minor compared to what’s happening on the balance sheet side of the business.

There are two ways a CRE loan defaults; an operating statement default, or a balance sheet default. Here is a typical CRE deal illustrating an operating statement default:


The assumptions are an initial interest rate of LIBOR+2.25% with a 30 year amortization, no changes in interest rates or cap rates, but a 25% decline in NOI. This results in negative cash flow, which could lead to a default (one would hope on a $10,000,000 deal the sponsor could cover a shortfall this small, but that capability is not something CRE lenders focused on). The takeaway point is, even with a major decline in NOI the shortfall is not huge, and because there is equity on the balance sheet the problem can be solved with a sale of the property.

Here is an example of a balance sheet default with the same structure, but a smaller decline in NOI coupled with an increase in cap rates:


Note that the operating statement side of the equation is fine; the borrower can still make the payments. However, the increase in cap rates has wiped out the equity in the property, and if the loan matures the borrower can’t repay it. The takeaway here is that cap rate changes have a much bigger impact than operating statement changes (for a more thorough analysis of this point, here’s a link to Philip Conner’s and Youguo Liang’s Income and Cap Rate Effects on Property Appreciation).

Here is what things are actually looking like for 2010 – a substantial decline in NOI and an increase in cap rates, combined with a substantial decline in interest rates:


Note that the operating statement is fine; the decline in interest rates more than offsets the decline in NOI, and cash flow has actually improved since origination. However, the decline in NOI combined with the increase in cap rates creates a huge balance sheet problem, and if the loan matures the problem can’t be solved with a refinance or sale of the property.

This is why there is so much concern over upcoming loan maturities. Here’s a link to a Deutsche Bank CRE presentation which goes into more depth (the maturity discussion begins on page 25).